What is a buy stop order?
A buy stop order is an instruction that self-directed investor can place through their broker to purchase a security when it reaches a pre-specified value above the current market price.
When the asset reaches the pre-determined or stop price, an order is placed to purchase the security. The buy stop order then becomes a market order that will be filled at the next available price on the market.
A buy stop order can be applied to various traded assets including stocks, Exchange traded funds (ETFs). Using a buy stop order is based on the underlying assumption that a share price that climbs to a certain level will continue to rise.
In addition to buy stop orders, there are other orders, such as limit order and a stop loss order. All of them are instructions for a broker or trading platform to buy or sell an asset at a pre-determined price automatically.
Buy stop order vs a stop loss order: What's the difference?
While a buy stop order specifies a buying price that is higher than the current market price, stop loss orders are essentially the opposite. They are a type of stop order with instructions to close out a position and sell when an asset falls below a certain level.
Stop loss orders can protect investors from volatile negative activity and help reduce the pressure of monitoring day-to-day trades. For example, a trader may buy a stock and place a stop loss order with a stop $5 below the stock's purchase price. If the stock price drops from $60 to $55, the stop loss order is triggered, and the stock will be sold at the stop price, or the next best available price.
Why place a buy stop order?
Why would an investor pay a higher price to buy a security when they can get it now at a lower price? It sounds crazy, especially since we’ve all learned that an investor should aim to buy low and sell high!
There are two main reasons why an investor would choose to place a buy stop order:
- To protect against the risk of unlimited losses of a short sell position
- To profit from an upward movement in a stock's price by placing an advance order
Why use a buy stop order when short selling?
If an investor is short selling, they are selling with the intention that the borrowed stock they have on margin will decrease in value. They sell the stock they have borrowed at the current price. If things work out as planned, the asset goes down in value.
They then buy back the same stock at this lower price and return it to the owner. The difference in the value between the higher sale price in the past and the lower repurchase price in the future is pocketed as profit. Because this type of trade can be complex and high risk, it is typically implemented by experienced investors
Short sellers often use buy stop orders to protect themselves in case the stock they are short selling increases in value.
The buy stop order helps them limit the risk of an 'unlimited loss.' By placing a buy stop order, investors can fix a price at which they buy back the stocks that they have shorted and hold on margin.
When it’s time to return the stocks, the buy stop order may not have eliminated all risk, but it will have significantly reduced and offset the extent of their losses.
The short seller has two motivations in placing a buy stop order, the first is to limit the amount of loss in the scenario where the shorted security’s share price goes up. The second scenario is that the share price of the shorted security has dropped, and there is an unrealized gain. The share price could still decrease but, by placing the buy stop order, the investor would like to protect a portion of the unrealized gain in case the share price increases.
Why use a buy stop order for technical analysis?
Using a buy stop order can also be helpful as part of a technical analysis, when deciding on which securities to invest in. If a stock seems bullish, but you aren't entirely sure about your decision, you may want to establish some indicators that the stock’s upward movement isn't a false start. , when deciding on which securities to invest in. If a stock seems bullish, but you aren't entirely sure about your decision, you may want to establish some indicators that the stock’s upward movement isn't a false start.
When looking for stocks with an upward trend, crossing moving averages, breaking out of trading range or breaking out from a resistance price, one way of testing your hunch would be to use the trading platform to set a buy stop order that is higher than the current price. , one way of testing your hunch would be to use the trading platform to set a buy stop order that is higher than the current price.
For example, the current price of stock Z is $50, and you've determined that if the price surpasses $55 the stock will be in a bullish trend for the foreseeable future. One way to profit from the upward movement in the stock price and automate the process is to set a buy stop order at $55.
You are willing to miss out on the initial $5 per share of growth to confirm that the bullish trend is substantive and indicative of the ongoing upward trajectory of the security before buying in.
Investors can also use momentum indicators such as the Relative Strengh Index (RSI) or MACD to help them validate how strong this upward price movement is before deciding if it’s worth buying.
How does a buy stop order work?
On our NBDB platform, entering a buy stop order is a straightforward process. Over and above choosing the account, the security, the number of shares, and price type, you will need to consider two categories: a stop price (trigger price) and a limit price.
The stop or trigger price is the price at which you decide to buy the stock. Since the stock is appreciating, the first available market price will likely be higher than the trigger or stop price. The limit price is the maximum you are willing to pay per share to buy the stock and close your market order. The limit price will always be higher than the stop price (trigger price).
How do I place a buy stop order?
Once an investor has decided to place a buy stop order in their short margin account or any other type of account
holding their securities, the initial steps are the same as placing any purchase order at NBDB.
- Click on the Buy button, an order ticket will appear with the account and shares information already completed.
- Specify the number of shares in the quantity box, then select Buy stop from the dropdown menu in the Price type box.
- Select the trigger and limit price and choose the length of time the order will be valid.
- Validate the order, then click on submit. An order summary will appear where the investor can review their order, then click on Confirm & Send Order.
What are the risks of using a buy stop order?
One of the risks of using a buy stop order when purchasing securities or short selling is that the stop order can be triggered by price increases that might be short lived and not indicative of continued growth.
For example, a sudden spike in the value of the security can trigger the buy stop order even if the asset loses value in the course of the trading day.
Another issue is setting a limit price that is too close to the trigger price. In a short position, if the share price increases sharply, the buy stop order might not be activated, and the losses can quickly add up.
Nevertheless, the benefit of using a buy stop order if an investor is short selling stocks is clear. If the stock the investor is trying to short does go up in value, the investor will be able to cover their short position for the losses that they have incurred for the total value of the margin loan stocks they hold, in addition to any interest and commissions.
In principle, buying on margin can amplify returns, but only if the investment outperforms the cost of the loan itself. If it does not, and things move in the other direction, investors can lose very large sums of money, very quickly.
Buy stop orders are useful tools for independent investors. They can be used to automate key processes and help manage the time spent day-to-day trading. But like all types of investing there are risks. But doing your homework and finding out more can help you grow your money.
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Key Takeaways
- Buy stop orders allow investors to profit from the upward movement of stock prices.
- Buy stop orders can be used to automate key processes and help manage the time spent on trading.
- Short sellers use buy stop orders to limit risk and hedge against the possibility of an increase in the value of the shorted stock.
- Buy stop orders have to be used carefully because they can be triggered by sudden price spikes that are not indicative of continuing growth.